Congress may ask homeowners' help to close tax gap

Kenneth Harney

Published 4:00 am, Sunday, October 29, 2006

2006-10-29 04:00:00 PDT Washington -- Watch out: Home real estate is back in the sights of Capitol Hill tax reformers.

The staff of the nonpartisan Joint Committee on Taxation has proposed new options for closing what is being called the tax gap -- the difference between federal taxes that should be paid under current tax rules and the actual amounts collected by the Internal Revenue Service. Recommendations from the committee staff carry substantial weight with members of the Senate and House, and frequently get included in tax legislation.

High on the list of methods to collect more of what's owed: Tighten up on homeowners' billowing write-offs of local and state property taxes, which cost the government about $20 billion a year in revenue.

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Under the federal tax code, local real estate taxes levied against homes generally are deductible. However, they are not deductible if the tax payments cover commonplace special assessments designed to pay for improvements that directly benefit taxpayers' real estate. Examples include local "user fees" for water mains, sewer lines, sidewalks, trash collections and trees.

The problem, according to the tax committee staff, is that federal law does not require local governments to tell the IRS about property owners' mixes of regular taxes and non-deductible special-benefit levies. Local governments often provide annual property tax statements to residents with breakouts of assessments. But many homeowners simply deduct the bottom-line taxes paid.

As a result, according to the committee, homeowners get to write off hundreds of millions of dollars a year for tax payments that are not legally deductible. In a 1993 study, the Government Accountability Office estimated that $400 million of that year's $11 billion in property tax write-offs claimed by homeowners were improper. With deductions this year running nearly double that amount, wrongly claimed write-offs could be in the $700 million range or more.

The committee proposes two solutions: Require local governments to provide copies of homeowner tax statements to the IRS with breakouts distinguishing between regular and special-benefit assessments; or require mortgage lenders and loan servicers to report details of homeowners' property tax escrows with similar breakouts.

Either way, the IRS would receive property tax information on millions of homeowners every year for possible audit purposes.

The second target on the committee's hit list is a much richer lode -- home mortgage interest deductions, a nearly $70 billion revenue loss to the government this year. One of the problems, according to the staff, is that many homeowners do not distinguish between nondeductible mortgage interest and legally deductible interest.

For example, many refinancers write off mortgage points, loan fees treated by the IRS as prepaid interest, in the year of the refinancing. But the IRS interprets the tax code to require that points in a refinancing be written off on a prorated basis over the full term of the loan.

Currently, lenders report annual mortgage interest payments to the IRS, but not whether a loan was a refinancing. The committee staff recommends the rule be changed to require a notification of all homeowner refinancings -- again providing potentially useful red flags for IRS audits.

Similarly, the committee proposes that lenders report whenever a refinancing led to a new loan amount $100,000 larger than the previous balance. That will alert the IRS to interest write-offs in excess of those permissible under widely misunderstood rules governing "acquisition indebtedness."

Acquisition debt for most taxpayers is the original mortgage debt they incurred to make their home purchase, plus all subsequent capital improvements, minus payments to reduce that principal over the course of the loan. Although many taxpayers believe that all mortgage interest is deductible on up to $1 million in mortgage debt plus an additional $100,000 in home equity debt, that is not the law.

Using an example supplied by the committee, if the owners of a home with a $500,000 mortgage did a "cash-out" refi of $700,000 -- that is, they pulled out an additional $200,000 -- the IRS might not view all the interest on the $700,000 new debt as deductible. Auditors might scrutinize whether the owners used more than $100,000 for capital improvements -- legitimate and tax-deductible as "acquisition debt."

If substantial sums were spent on new luxury cars or vacations, by contrast, those portions might not qualify for federal interest deductions.

To raise the red flag on these cash-out refinancings, the committee proposes requiring lenders to alert the IRS in annual mortgage interest reports whenever taxpayers increase their loan balances by more than $100,000 through refinancing.

The committee says it cannot be certain how many of the recent tidal wave of cash-out refis may have produced interest deductions that exceed the rules, but given the sheer amounts involved, "even low levels of noncompliance" might add up to big bucks.

Where's this all headed? Don't be surprised to see both proposals surface next year in tax legislation -- no matter which party controls Congress.